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Financial Engineering does help minimize risk
in any investments. If you look at the history of
the evolution of derivatives, you can see that it
was initially used by farmers to fix the price they
were going to sell after the harvest. CBOT which
is the oldest Futures exchange was established
in 1848 for this purpose. But people quickly
realized that they can make quick profits if
they buy and sell these futures contracts itself.
Of course they were not farmers who sold the
commodities nor were they merchants who
actually wanted to buy these commodities.
One way of defining risk is the probability that
I get my money back with some interest i.e the
other person will not default on me. Consider
the example of CDOs. CDOs are financial instru-
ments in which a bank which has issued loans
to its customers groups them together and sells
it off to an investor. The investor makes money
on them by the interest payments made by
the loan takers. Now if the bank just acts as an
intermediary and its main source of money is
by selling the CDOs, it wants to give away as
many loans as possible without much thought
about the creditworthiness of the loan taker.
Now the investor who buys the CDOs with
these bad loans will lose money because the
loan taker defaults on his payment. This is what
happened during the credit crisis of 2007.
You cannot blame the Financial Engineer/
Quant who designed the CDOs. If they were
used the way they were intended to, then
there wouldn’t be any problem with the de-
rivatives or any other financial instruments.
Let’s look at the efficiency of these derivatives
products. There are various types of investors-
risk takers, value investors, day traders. The
reason we have so many financial instruments is
to serve all these people. So, with the evolution
of the financial market the market efficiency
increases. Investors are free to choose from
wide variety of available financial instruments.
There is one caveat though. As with most
mathematical models, there are a few un-
derlying assumptions. You can easily distort
the truth by changing these assumptions
or just ignoring some assumptions. So it’s
very important that you know which as-
sumptions can go wrong and let everybody
know who use your mathematical model.
- Venkatesh Kaulgud
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Financial Engineering:
What is the purpose of Financial
Engineering?
